Are individual investors really bullish?

Thomas H. Kee Jr. is the president and CEO of
Stock Traders Daily (dotcom), where he offers strategies and newsletters to
both institutional and individual investors, and he manages money privately for
both institutional and individual investors through Equity Logic LLC. A
specialist in technical analysis, Kee is also the founder of one of the leading,
longer-term fundamental economic and stock market indicators in history, The
Investment Rate. This proprietary tool, which is available to clients, too,
predicts major economic cycles well in advance, and has been accurate since
1900. Using his broader observations of the economy to define disciplines, Kee
has been able to accurately predict market cycles in advance using his
multi-tiered technical indicators, and that combination has kept him ahead of
the curve since starting Stock Traders Daily in January 2000.

Individual investors have come across as so confident that they appear arrogant at times. That’s off-putting to anyone who specializes in risk-controlled strategies because when smaller investors are overly confident, they don't care about risk control at all.

Recently, however, I have come to question observations I have made about individual investors being overconfident and arrogant. I have my finger on the pulse of the smaller investor, having written articles and providing risk-controlled trading strategies to smaller investors for over 20 years. I keep a close eye on the sentiment of this group.

Thankfully, many of my clients are also fund managers, and that helps me understand both sides of the sentiment spectrum, but at times it does appear as if the lines cross. When looking specifically at individual investors, I have found them to be overly confident at first glance, but when we add in other variables, I recognize that my assessment could be wrong.

One of my hedge fund clients brought up a point that helps clarify this issue. He said the recent American Association of Individual Investors report on investor sentiment was actually down 5.3 percentage points to 32.4% bullish. If smaller investors are as arrogant as I thought they were, I had to ask myself why that report showed that so few in the survey were actually bullish.

That made it clear that another important variable needed to come into play. There are reports that smaller investors have been putting money into the stock market at a pace that is about 10 times faster than at any other time in recent history. Although many market professionals consider that to be a red flag, it also plays a role in my reconsideration of my initial observation of individual investors.

Think about those two variables for a minute: They are not bullish, but they are investing at a rate that is 10 times faster. Something seems amiss.

What I once thought was arrogance may actually be something completely different. Smaller investors may be pouring money into the market even though they perceive tremendous amounts of risk. But they just don't want to miss another rally, as some did in 2013. The individual investor may be buying stocks aggressively even though they perceive risks to be extremely high, and that makes them appear to me as if they are arrogant.

I will be specific with two Dow stocks that have recently reported earnings. Both General ElectricGE, +0.79%
and HoneywellHON, +0.50%
are important Dow components, and each trade with price-to-earnings multiples at very high levels. However, in the chart patterns below, we can see that the EPS growth rates don’t warrant the P/E multiples levied on the stocks.

With every fundamental observation comes a technical observation, and that is where smaller investors took issue with my work. When I pointed out where longer-term resistance levels, saying the stocks could fall hard when taking into account EPS growth, they seemed say in unison “there's no way that could happen.”

Their response was that I was a fool to believe that these companies’ shares could ever fall because management was so good and bullish about their prospects.

Anyone who has been in this market for the past 20 years has heard that before, and initially that appears to be an arrogant point of view, but it could instead be a sign that individual investors have simply thrown in the towel and they're buying and convincing themselves that stocks will go up forever even though they perceive a tremendous amount of risk.

Either way, these are red flags. Whenever smaller investors become this active, it is a concern, but they may not be bullish. Instead they may simply be buyers.

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